Analyst Ratings And The Institutional Imperative

Buffett talks a lot about the concept he calls the “institutional imperative”. In his 1989 shareholder letter, when he was describing his mistakes of the first 25 years managing Berkshire, he outlines what he means by this (emphasis mine):

“My most surprising discovery: the overwhelming importance in business of an unseen force that we might call “the institutional imperative.” In business school, I was given no hint of the imperative’s existence and I did not intuitively understand it when I entered the business world. I thought then that decent, intelligent, and experienced managers would automatically make rational business decisions. But I learned over time that isn’t so. Instead, rationality frequently wilts when the institutional imperative comes into play.

“For example: (1) As if governed by Newton’s First Law of Motion, an institution will resist any change in its current direction; (2) Just as work expands to fill available time, corporate projects or acquisitions will materialize to soak up available funds; (3) Any business craving of the leader, however foolish, will be quickly supported by detailed rate-of-return and strategic studies prepared by his troops; and (4) The behavior of peer companies, whether they are expanding, acquiring, setting executive compensation or whatever, will be mindlessly imitated.

“Institutional dynamics, not venality or stupidity, set businesses on these courses, which are too often misguided. After making some expensive mistakes because I ignored the power of the imperative, I have tried to organize and manage Berkshire in ways that minimize its influence. Furthermore, Charlie and I have attempted to concentrate our investments in companies that appear alert to the problem.”

Institutional Imperative

There was a really interesting article in the Wall Street Journal on Friday that highlight a few examples of the conflicts of interest that exist in the relationship between Wall Street analysts who write research and make recommendations, the clients who pay for that research, and the companies that are the subject of the research.

The institutional imperative in this case is the emphasis and importance that publicly traded companies place on what Wall Street analysts think about the stock price of their company. Focusing on your stock price and caring about what other people think about it is counterproductive, as it creates a major distraction to focusing on what is important: running the business.

Here are a few quotes from the article outlining the value companies place on “buy” ratings:

Analysts who want top executives at Coach Inc. to attend private events with their investor clients have to show they are “brand ambassadors,” as the luxury handbag retailer dubs it. You can’t be a brand ambassador if you have a sell rating on Coach’s stock.

I’m not sure how much analysts care about being “brand ambassadors”, but often times their pay is directly linked to their ability to get clients access to top-level management:

Many securities firms tally the number of times their analysts take company executives on the road to meet clients and use the number to help decide analysts’ annual bonuses.

At some firms, as much as one-third of analysts’ yearly pay can be tied to corporate access…

So analysts are much more incentivized to write glowing reports about companies with “buy” ratings than risk getting their access to management (and their bonuses) cut off:

“It’s a decision I have to make on my sell-rated stocks: whether I will forgo the opportunity for corporate access, which clients will explicitly pay for,” says Laura Champine, a retail analyst at Roe Equity Research. Some previous bosses at other firms told her to “just drop coverage” instead of putting out sell ratings, she says, while declining to comment on where that happened.

“When your compensation is in part based on how many meetings you set up in a given year, it’s really tough to stick to your guns,” says Eric Hollowaty, a former analyst at Stephens Inc. who covered consumer companies.

With a collection of some of the most valuable media and entertainment assets in the world that will be producing sizable royalty fees for decades to come, you wouldn’t think Disney would care all that much about where someone thinks the stock price will go over the next few quarters, but unfortunately that doesn’t seem to be the case:

Media analyst Richard Greenfield of BTIG LLC says his emails, phone calls, and a request for an investor meeting with Walt Disney Co. have gone unanswered since he issued a sell rating on the company in December 2015.

The rating went out on the same day as the world-wide release of “Star Wars: The Force Awakens.” Before then, when Mr. Greenfield had a buy rating on the stock, he was regularly invited to Disney events and once hosted a meeting between a group of investors and a Disney executive, the analyst says.

“Everything changed when we went to a sell,” says Mr. Greenfield. When Disney invited more than 50 analysts and investors to the opening of its Shanghai Disneyland resort last summer, Mr. Greenfield was left out.

Here is a clip that exemplifies how important information is to large investors (and this info is almost always short-term info that could impact the stock this quarter):

Banks and brokerages often poll large investors on the services they value most highly. Private meetings arranged by analysts are cited among the top reasons why investors steered trades through the banks and brokerages.

That decision is important because commissions from such trades are part of the lifeblood at many financial firms. Competition has intensified since the financial crisis because the pool of available commissions is shrinking from price cuts and the rise of automated trading.

Christopher King, a former Stifel Financial Corp. analyst, recalls asking Sprint Corp. for meetings with clients when he had a hold rating on the wireless telecommunications company a few years ago. He says a Sprint investor-relations officer asked why it should oblige when he didn’t have a buy rating.

Two analysts who still follow Sprint say their investor-meeting requests also were been rebuffed when their ratings were negative. Twenty analysts have a buy or hold rating on Sprint, while nine rate the stock a sell, according to Thomson Reuters.

The Edge Gained From Thinking Long-Term

I have talked recently about the concept of time arbitrage. See this post, which outlines my thoughts on where investors can find an edge (note: it’s not in reading Wall Street research or even acquiring hard-to-get pieces of information). But the fact that so many market participants are focused on getting access to company management in hopes to pluck nuggets of useful information (that almost always is related to attempting to predict short-term market movements) means that investors who pay no attention to this noise and just leapfrog this short-term time horizon can gain a significant behavioral edge.

The WSJ article also exemplifies company behavior that is counterproductive to creating long-term value. Why would long-term owners of Disney care about whether analysts think the stock will go lower over the next 12 months? And more significantly—why would Disney’s management team care where analysts think the stock price will go this year? Any time spent considering analysts’ opinions is time spent not being focused on operating the business.

There are some cases where companies need cooperation from Wall Street because their business model relies on accessing the capital markets (MLP’s, real estate investment trusts, companies engaged in serial acquisitions, to name a few). These aren’t ideal business models because the future of those companies depends in large part on how Wall Street and the capital markets view them. But for most companies, especially one with the brand and the assets that Disney has, I think any time spent reacting to analysts’ opinions is a distraction and carries a fairly significant opportunity cost over time.

I realize there are very few publicly traded companies that act the way Berkshire Hathaway does (in terms its relationship with Wall Street, executive pay, corporate governance, stock options, etc…), but it’s still a point worth making. If you’re a long-term owner (or manager) of a business, you should focus on running your business. Market and promote your products and services, not your stock price.

“I have some problems with having meetings with some sub-groups of investors. If we had them, I’d want meetings with everyone. We try to convey a lot about our business in our annual report.

“I don’t think it fits our temperament at all. Many corporations spend a lot of time talking to analysts. One of our strengths is not doing this. It’s very time-consuming and gives some shareholders an advantage. We’re very egalitarian.

“We’re not trying to appeal to people who care about next quarter or year. We want to appeal to people who view this as a lifetime investment. There are relatively few investors who think about buying and putting it away forever like a farm.”

It would be beneficial if more companies followed this type of attitude. Ironically, the thing many companies seem to care about the most (its stock price) would likely do much better over the long run if the distraction of worrying about analysts’ ratings was eliminated.

John Huber is the portfolio manager of Saber Capital Management, LLC, an investment firm that manages separate accounts for clients. Saber employs a value investing strategy with a primary goal of patiently compounding capital for the long-term.